Markets await rate reduction and stabilised inflation dynamics

However, RBI is worried about food basket inflation which was still high at 8.52% in March, down from 8.66% in February. RBI has forecast an inflation target of 4.5% for this fiscal year assuming normal monsoon

In the light of inflation moderating from its peak level, it is natural that markets and common people look to the when, how and what percentage of rate cuts are effected by central banks. However, central banks are still not sure that the headline inflation has been brought under control, reined in to full extent and they are able to reach the target rate on a durable and enduring basis. This has been further complicated by the continuing geo political situation, war and tensions and their impact on supply chains, particularly free movement of food items.

This will lead to volatility in commodities prices, particularly oil. Another reason is the continuing heat waves, climate disasters, and possible deficit rainfall, floods that damage food crops, storms and heat waves.

It has become therefore difficult for the central banks to gain victory over inflation on a durable basis as they would not like to just celebrate a temporary victory over inflation and loosen policy prematurely in response to initial decline in prices pressures.

History shows that whenever there were changes in tight monetary policy without complete resolving of inflation, it has always come back. It is in this background, that he current phase of higher inflation has been persisting for a longer time and central banks have been continuing to pause even though there are enough successes to rein inflation and currently it is expected that they will start the policy of reducing benchmark rates.

There are pains when a tight monetary policy is in vogue and there could be a brief adverse impact on GDP growth.

However, with low inflation and price stability, growth will be at a higher level in the medium and long-term with inflation below the targetted level. According to an IMF study, five years after the inflation shock, countries which addressed inflation issues on a priority basis had higher growth and lower unemployment than economies that allowed inflation linger for a longer period.

A prudent fiscal policy and efficient monetary policy can achieve macroeconomic stability and help in fighting inflation, achieve price stability and result in good GDP growth on sustainable basis. It calls for combination of action from the monetary policy perspective as well as measures from the supply side by the respective government coupled with fiscal prudence will enable to get control on inflation on a sustained basis.

One important aspect to look into will be the situation when Federal Reserve will start cutting benchmark rates. This will have a global impact. Federal Reserve in their March 2024 monetary policy, continued to hold the line on interest rates in the range of 5.25% to 5.50%. It marks the fifth consecutive meeting with no change in interest rates after raising rates eleven times in less than one year between 2022 and 2023.

Fed Chair Jerome Powell stated that "The Committee does not expect it will be appropriate to reduce the (fed funds) target range until it has gained greater confidence that inflation is moving sustainably towards 2 per cent."

It may be noted that US consumer inflation in March rose 3.5% from a year ago, which is more than expected. It is expected that Fed will have few rate cuts this year.

Bank of England has also kept interest rates high at 5.25% with the aim to control inflation to their target of 2% which they expect to reach in the next few months, before rising slightly.

“We will keep interest rates high for long enough, so inflation settles at 2%,” says Bank of England, which has raised interest rates over the past two years to help slow down price rises (inflation) and inflation in the UK has fallen from a peak of 11% in 2022 to 3.4% in February 2024.

European Central Bank in March 2024 decided to keep the three key ECB interest rates unchanged at 4 50%, 4.75% and 4% on main refinancing operations, marginal lending facility and deposit facility respectively. Eurostat data for March revealed a drop in annual price consumer price inflation to 2.4% below the expected 2.6% and hitting a four-month low.

We need to look at the RBI monetary policy from the above perspective as it has repeatedly reiterated that they are on target to achieve the inflation target on durable and sustainable basis and keeping the repo rates unchanged at 6.5%, even though core inflation has eased substantially. There is also ease of headline inflation, which as on March 10, was at a month low of 4.85%. However, RBI is worried about food basket inflation which was still high at 8.52% in March, down from 8.66% in February. RBI has forecast an inflation target of 4.5% for this fiscal year assuming normal monsoon. Brent crude price has reached $90.45 per barrel, which is not good news for India. The continuing heat waves in India and elsewhere pose threat to availability of sufficient water for agriculture and drinking as most reservoirs have become half empty. This will get further complicated if there is no normal monsoon due to the EL Nino effect and climate change.

As regards India, our GDP growth has withstood the impact of inflation and real GDP growth has been on higher level, above the seven per cent projected for the financial year in view of the proactive measures taken by the government as well as prudent monetary and fiscal policy.

Elsewhere in the world, there has been large impact on GDP growth with projected global growth at 3.1% in 2024 and 3.2% in 2025. It is to be noted that US economy has been doing fairly better at 3.4% in Q4 2023.

Even though markets expect rate reduction to start in the current year, it is still not clear when and at what phase these will start. They are waiting to take cue from Federal Reserve.

(The author is former Chairman & Managing Director of Indian Overseas Bank)